Answer:
a) Langley buys $400,000 (gross) in medical supplies a year from Consolidated. The net purchases (the true cost of the supplies) is only 0.975 x $400,000 = $390,000 because they can be bought at a 2.5 percent discount when payment is made within 10 days. On a daily basis, Langley purchases $390,000 / 360 = $1,083.33. If Langley takes the free credit and pays on Day 10, its payables from Consolidated would total 10 x $1,083.33 = $10,833.33, which is the amount of free credit.
b. If Langley pays after 45 days, its accounts payable will increase to 45 x $1,083.33 = $48,750. Thus, the amount of costly trade credit is Total trade credit – Free trade credit = $48,750 – $10,833.33 = $37,916.67.
c. Langley is foregoing a 2.5 percent discount on its $400,000 of purchases, so the dollar cost of the additional (costly) trade credit is 0.025 x $400,000 = $10,000. Dividing this dollar cost by the amount of additional credit provides the approximate percentage cost of the costly trade credit:
$10,000
Approximate percentage cost = ──────── = 0.264 = 26.4%.
$37,916.67
Of course, the approximate cost could have been found by applying the following formula:
Discount percent 360
Approximate % cost = ────────────── = ────────────────────────
100 - Discount percent Days credit received - Discount period
2.5 360
= ─── = ─── = 0.264 = 26.4%.
97.5 35
d. If Langley can obtain a bank loan for less than 26.4 percent cost, including interest cost and fees, it should replace the costly credit ($37,916.67) with a bank loan.
e. As indicated in Part d, only the costly trade credit should be replaced. Langley should always take the $10,033.33 of free trade credit.